Commercial Office Space Still Struggling – Houston In Trouble

Commercial real estate needs to be viewed from several different perspectives. One of the most important differentiations is by size of the property. Measured by square footage, 71 percent of commercial real estate has more than 17,000 square feet. Yet, when measured by the count of properties, those below 17,000 square feet make up 80 percent of the existing market. Another important viewpoint is the sub-lease market, which is much more active for commercial real estate than for residential real estate. Of course, other natural segments include retail space, office space, manufacturing, apartments, etc.

During the Great Recession, much (or most) of the Texas economy was spared the financial suffering the majority of the country experienced. This was primarily due to the then strength of the energy sector, especially oil, which Texas, and primarily Houston dominates. Today, some of the large commercial loans made in the office sector are coming back to haunt Houston.

Houston Based Collateral Added to Morningstar Watchlist

Morningstar Credit Ratings, LLC added several loans to the Morningstar Watchlist totaling $263.5 million backed by Houston collateral in November. More than two times the balance added for the second-most active market, Washington, D.C. Furthermore, over the past 12 months, the balance of Houston loans on the Watchlist has grown by more than 50% to $748.1 million, moving Houston up to have the fifth-largest Watchlist exposure from 15th largest in November 2015. Much of the increase can be attributed to 2007 loans, whose Watchlist exposure more than tripled, and 2013 loans, which saw a 188.2% increase over the past 12 months.

These additions come at a time when the energy industry is under pressure because of the volatility in U.S. crude-oil prices, which has had a significant effect on the Houston economy and commercial real estate, particularly the office sector. U.S. crude oil is trading around $50 a barrel as of the date of this publication, up from under $30 a barrel in February, but well off highs near $100 a barrel in 2014, according to The Wall Street Journal.

Office vacancy increased nearly four percentage points to 14.6% in the third quarter of 2016 from 10.8% in 2014, according to CoStar Group, Inc. Sublease space pushes the total availability to roughly 20.0%. CoStar expects office rents to finish 2016 with their slowest growth rate in five years and to start dropping over the next two years. Supply growth could exacerbate an already weak situation, as more than 3 million square feet of office space will hit the market over the next two years. However, there may be hope. Bisnow reported, citing research from Jones Lang LaSalle Inc., that sublease activity recently picked up, with the inventory of sublease space decreasing by 5% so far in the fourth quarter to 11.8 million square feet. In addition, if it follows through, OPEC’s recent agreement to cut oil production to spur an increase in oil prices should benefit energy-dependent cities like Houston.

Large Houston Office Loans Added to the Watchlist

3 Westlake Park is where ConocoPhillips’ has 242,052 square feet, or 57.7% of the gross leasable area. The 419,671-square-foot building, which secures an $80.0 million loan is just 59% occupied since a major tenant, BP Amoco Corp., vacated at its November lease expiration. However, Morningstar doesn’t view the loan as a near-term default risk because the property can still cover its debt service. ConocoPhillips will continue to pay rent for an additional three years even without a subtenant.

717 Texas Avenue, this $160.0 million loan is also not a near-term default risk. It was added to the Watchlist because of the sizable amount of available space for sublease or direct lease at the nearly 700,000-square-foot office building in downtown Houston as the loan heads into its July 2017 maturity. As of December 2016, the property is 100% leased, but there is 53.6% of the gross leasable area, or 373,292 square feet, available for sublease, including 192,582 square feet of vacant space, according to CoStar. While the leases of four of the five largest tenants extend past maturity, three of the five are tied to the energy industry.

10333 Richmond, has a $34.7 million loan with about one third of the property’s space available, up from the reported 22% vacancy in June, according to CoStar. This prompted the addition to the Watchlist. Morningstar believes that this loan has elevated default risk, as the debt service coverage ratio may fall to below break-even from 1.14x in June. In addition, the property’s value has slipped since issuance, dropping to $27.6 million (using a discounted cash flow analysis), which yields a concerning LTV of 125.7%. The property is a 218,680-square-foot office building in the Westchase neighborhood of Houston.

801 Travis, this $28.6 million loan was added to the Watchlist because the collateral, a 220,382-square-foot office property in the Houston central business district, has about 38% of the space available for lease, which includes space previously occupied by the second- and third-largest tenants. Morningstar expects the cash flow to decrease in 2017.

9801 Westheimer Road, the $14.6 million loan was added because of the loss of the largest tenant and high 2017 lease rollover at this office building in the Westchase submarket will limit the borrower’s ability to secure take-out financing by the loan’s November 2017 maturity date without additional equity. The largest tenant at underwriting, that had 22.4% of the property’s gross leasable area, vacated in June 2016 when its lease expired. October occupancy for the 207,254-square-foot property stood at 70.5%, according to CoStar, down from 90.0% in June.

While office buildings make up the largest property type added to the Watchlist in November, Morningstar is also seeing weakness in other Houston property types as job losses from energy-related sectors weigh on demand. For instance, added were two multifamily property loans. The $13.0 million Champions Centre Apartments loan with a $100,000 value deficiency and the $5.7 million Colonial Oaks At Westchase loan with a $1.8 million value deficiency.

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Author bio: Brian Kline has been investing in real estate for more than 35 years and writing about real estate investing for 10 years. He also draws upon 30 plus years of business experience including 12 years as a manager at Boeing Aircraft Company. Brian currently lives at Lake Cushman, Washington. A vacation destination, a few short miles from a national forest. With the Pacific Ocean a couple of miles in the opposite direction.